5 Covered Call Ideas for Feb. Expiration

Conservative and aggressive investors can earn steady monthly income by following certain strategic guidelines and choosing quality underlying stocks such as these, which are set up nicely for next month’s expiration.

Writing covered calls for income has been a popular strategy for traders and investors alike since standardized option contracts were first introduced in 1973. Many traders and investors are happy with a modest rate of return, as long as it’s fairly predictable and consistent. Or, if you’re a risk loving investor seeking extraordinary returns, it is also possible to use covered call writing more aggressively.

Playing it relatively safe with covered calls means choosing underlying stocks with these attributes:

Large market cap. There are 508 stocks with market caps over $10 billion. That’s a good place to start. Even some mid-caps might be okay (if they are not “story” stocks or momentum stocks). But conservative investors should definitely stay away from small-cap stocks

Pays a dividend. There are 396 stocks with market caps over $10 billion that pay dividends. Average annual dividend yield of these 396 stocks is 2.54%. These companies paid a total of $240 billion in dividends in 2011, up from $205 billion in 2010. Ideally, there will be an ex-dividend date prior to option expiration so that you get some dividend income in addition to the call premium

No earnings before expiration. This is only for new buy-write positions. If you are writing calls on your long-term holdings, then you can ignore this rule

Proper holding period. Only buy stocks you are comfortable holding for many months, even if you are doing in-the-money buy-writes

Construct a portfolio of large-cap dividend payers and then write in-the-money calls and you should have a portfolio that will deliver consistent income. A conservative rule of thumb is to target covered calls paying 12%-24% per year (1% to 2% per month).

Writing Covered Calls the Aggressive Way

More aggressive and/or risk-loving investors, which includes anyone seeking more than 2% per month, can adopt this style of writing covered calls:

Write at-the-money calls. Write at-the-money calls instead of in-the-money calls. You’ll get better returns but have less downside protection. If stock is flat or goes up (before expiration) then you’ll maximize your time premium

Write calls on momentum-based stocks (not recommended if you are risk or volatility averse). In the past, this would have included high flyers like Research in Motion (RIMM), First Solar (FSLR), and Netflix (NFLX). It’s great while the momentum lasts, but painful when they reverse (even if you’re writing deep-in-the-money calls). Having a stock crater 50% or more is difficult to recover from with covered calls

Don’t seek the highest annualized yield. Don’t just go for the highest annualized yield without regard for what the underlying company does and without understanding why the premiums are so high. Do your homework and understand what’s going on with the company before you buy

Trade on margin. You can always increase returns (and risk) by adding more leverage. If you have over $100K, then some brokers will give you portfolio margin, which is about 5.6x leverage (compared to 2x leverage normal Reg. T margin gives you)

While it is possible to earn 4% to 6% in a month with covered calls, those kinds of returns are unlikely to be reproducible over a large number of months. Most people claiming such results are using heavy margin, or are playing with high-Beta (volatile) stocks and do not have consistent month-to-month returns.

Realize that 5% per month is 60% per year. Common sense says that’s not realistic (or possible) over the long haul.

Covered Calls for February Expiration

Here are a few covered calls to consider for the Feb. 18 expiration. They include Hewlett-Packard (HPQ), Dell (DELL), Oracle (ORCL), Walgreen, Inc. (WAG), and Pepsico (PEP).